Business Law Today August 2011

Small Business and the Corporate Opportunity Doctrine By Mitchell L. Marinello and Christopher G. Dean

The corporate opportunity doctrine pro- of an opportunity that is in the company’s interested from exploiting the hibits a corporate fiduciary from exploit- line of business, “the fiduciary must first opportunity, even in cases where he or ing an opportunity related to the corpora- disclose and tender the opportunity” to she reasonably believes the company is in- tion’s business unless he or she first offers the company. As the Supreme Court of capable of claiming the opportunity. Thus, that opportunity to the . There Illinois explained in Kerrigan v. Unity in Kerrigan, the court held that defendant- is no question whether the doctrine applies Savings Association, 58 Ill. 2d 20 (1974), directors’ belief that their savings and to small businesses. Indeed, countless “[I]f the doctrine of business opportunity loan association was precluded by law cases confirm that it does. The more in- is to possess any vitality, the corporation from capitalizing on an opportunity in the teresting question is how it applies, given or association must be given the opportu- insurance business could not “operate as the unique characteristics of many small nity to decide, upon full disclosure of the a substitute for [their] duty to present the businesses. In the small-business setting, pertinent facts, whether it wishes to enter question” to the corporation for indepen- challenges may arise as to whom, if any- into a business that is reasonably incident dent evaluation. one, the opportunity must be disclosed; to its present or prospective operations.” whether the holder of a distributional Despite the heavy emphasis the doctrine Application to Small Businesses interest in the business can challenge the places on disclosure, the law of some Disclosure of a corporate opportunity is, business’ decision to turn down an oppor- states does not require the formal presen- at least in theory, a simple process: The tunity; what happens when basic corporate tation of a potential opportunity when the interested fiduciary tenders the opportu- formalities are not followed; and whether company does not have any interest in nity to the company, fully discloses all the persons taking the opportunity have pursuing the opportunity or the financial pertinent information, and disinterested violated any duty to the business’ credi- ability to engage in it. In Broz v. Cellular then evaluate whether the com- tors. This article explores those issues. Information Systems., Inc., 673 A.2d 148 pany should engage in the opportunity. (Del. 1996), for example, the Supreme The problem, however, is that this process Rule of Disclosure Court of Delaware held that presentation does not always neatly apply in the con- The officers, directors, and shareholders is a form of safe harbor, “which removes text of a small business, where (1) each of a small business owe a fiduciary duty to the specter of a post hoc judicial deter- fiduciary may want to pursue the opportu- their company that includes the obligation mination that the director or officer has nity for himself; (2) distributional interests to refrain from usurping so-called corpo- improperly usurped a corporate opportu- may be held by someone other than an rate opportunities that rightfully belong nity.” The courts of other states, including owner; (3) corporate formalities are not al- to the company. A corporate opportunity George, Rhode Island, and Connecticut ways observed; and (4) the company may exists when a proposed activity is reason- have adopted similar approaches. be insolvent or nearly insolvent. ably related to the company’s present or But this “safe harbor” is not universal. prospective business and is one in which Illinois courts, for instance, view the Absence of Disinterested Fiduciaries the company has the capacity to engage. failure to disclose a corporate opportunity An interesting practical question can arise The corporate opportunity doctrine is, in as undermining the “prophylactic pur- in small businesses when every owner essence, a rule of disclosure: When a com- pose” of the rule. In such circumstances, knows about or is personally interested in pany’s fiduciary wants to take advantage the failure to disclosur “forecloses” the the corporate opportunity. What happens

Published in Business Law Today, August 2011. © 2011 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 1 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Business Law Today August 2011 when there are no disinterested officers, corporation had “necessarily consented” In short, where the usurpation of a directors, or owners to evaluate an oppor- to diversion of its assets through the acts corporate opportunity from a small busi- tunity on behalf of the business? Must the of its sole owners and officers, who were ness necessarily involves the “knowledge opportunity be presented to a disinterested accused of usurping opportunity. To the and assent” of the corporation (Tufts) or third party for independent evaluation? same effect is In Committee of Unsecured ratification by the shareholders Safety( In re Tufts Electronics, Inc., 746 F.2d Creditors of Specialty Plastic v. Doem- International), there can be no claim 915 (1st Cir. 1984) (Massachusetts law), ling, 127 B.R. 945, 952 (Bankr. W.D. under the corporate opportunity doctrine. was one of the first cases from any ju- Pa. 1991), where the court reversed a With the exception of insolvency, ex- risdiction to consider this issue in detail. usurpation finding because the corporate plained below, this rule is true even where There, the former president, director, and opportunity doctrine was “difficult to the consenting or ratifying fiduciaries are sole shareholder (Martin) of a bankrupt apply” to a small business where “there personally interested in the opportunity. corporation appealed from the judgment were no other shareholders to whom [the of the district court that had affirmed sole fiduciary] owed a duty of disclosure Transfer of Distributional Interests the imposition of a constructive trust on and loyalty.” And in Pittman v. American Many small businesses are structured as property he personally owned. Martin had Metal Forming Corp., 649 A.2d 356 (Md. companies. A distribution- acquired the property in part with corpo- 1994), the court, upon surveying the law al interest in a limited liability company rate funds, and then leased the property in other jurisdictions, held that the sole ordinarily is a transferable asset, and it is back to his corporation. The bankruptcy shareholder could not not liable for usur- not uncommon for a member of an LLC and district courts had found that, under pation of a corporate opportunity in the to transfer his or her distributional interest the corporate opportunity doctrine, Martin absence of any harm to creditors. to a person who has no ownership interest had breached his duty to the corporation The logic of these cases is compelling. in the business, such as a creditor. That by using corporate funds to help purchase After all, as the Seventh Circuit recog- raises the question of how, if at all, such the property for himself rather than for the nized in In re Doctors Hospital of Hyde a transfer affects a fiduciary’s disclosure corporation. Park, 474 F.3d 421 (7th Cir. 2007), a sole obligations under the corporate opportu- The First Circuit Court of Appeals dis- shareholder can “hardly . . . defraud[] nity doctrine. agreed. Emphasizing that Martin was the himself or breach[] a fiduciary duty to The transfer of a distributional interest sole shareholder, director, and president himself.” Other courts have reached the does not confer an ownership interest or a of the company, the appellate court held same conclusion, as in In re Hearthside fiduciary relationship with the company’s that the corporate opportunity doctrine Baking Co., Inc., 402 B.R. 233 (Bankr. other members. The consequences of was inapplicable because Martin’s actions N.D. Ill. 2009) (a “sole shareholder does this are twofold. First, the transferee of “necessarily involve[d] the knowledge and not owe a fiduciary duty against its own a distributional interest is not entitled to assent of the corporation.” The court fur- corporation and cannot breach a fidu- exercise the rights of a member, which ther recognized that even though Martin ciary duty to itself”); and In re Gordon include challenging––either directly on and the corporation were separate persons, Car & Truck Rental, Inc., 65 B.R. 371, its own behalf or derivatively on behalf “absent some element of defrauding, 376 (Bankr. N.D.N.Y. 1986) (corporate of the company––the supposed usurpa- Martin was not obliged, in every action he opportunity doctrine inapplicable where tion of a corporate opportunity. Second, as took, to prefer the corporation’s interests sole stockholders and officers “cannot be a corollary, corporate fiduciaries are not to his own. No one could operate a corpo- accused of withholding information from obligated to disclose the opportunity to ration solely on such a basis.” themselves”). some independent third party for evalua- A number of courts in other jurisdic- A minority of courts have reached the tion merely because a non-owner holds a tions have applied similar reasoning to same result through a different-but-related distributional interest in the company. reach the same conclusions. For example, doctrine––ratification. For example, in In fact, the authors of this article in L.R. Schmaus Co. v. Commissioner of In re Safety International, 775 F.2d 660 recently defended the sole members of a Internal Revenue, 406 F.2d 1044 (7th Cir. (5th Cir. 1984), the Fifth Circuit held that limited liability company, a husband and 1969) (Wisconsin law), the court found “even when [a] transaction is detrimental wife, against a claim that the husband had that “if an officer of the company owns all to the corporation, no cause of action will usurped an opportunity of the LLC in pre- the stock, he may use the corporate assets lie if all of the [interested] shareholders cisely this situation. The usurpation claim as he sees fit and there can be no misap- have ratified the transaction.” Accord- was brought by a judgment creditor of the propriation of corporate assets by him.” ing to the court, “[e]ven if [the directors/ wife who had used part of its judgment Likewise, in Mediators, Inc. v. Manney, shareholders] breached their duty to [the to acquire her distributional interest in Adv. 93 Civ. 2304 (CSH), 1996 WL corporation] by taking the purchase option the company. The creditor argued that the 297086, at *10 (S.D.N.Y. June 4, 1996) in their own names, no party to this action husband could not take a corporate oppor- (New York law), the court dismissed a can complain of the breach. There are no tunity without first formally tendering the corporate opportunity claim because the non-consenting shareholders.” opportunity to the company and having

Published in Business Law Today, August 2011. © 2011 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 2 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Business Law Today August 2011 it evaluated by some independent person. actually tendered to the corporation? Were breached no duty to McCook because he According to the creditor, if the husband the pertinent facts fully disclosed? Did the had disclosed the opportunity to purchase had not taken the corporate opportunity board or shareholders in fact agree that the smelter to McCook’s other members, for himself, the company would have the business should not pursue it? The fact who agreed that a separate entity should profited from the opportunity and would that the answers to these questions cannot make the acquisition. The bankruptcy have had assets to distribute, which would be found in board meeting minutes or court rejected this argument because the have benefitted the creditor. The trial court shareholder ballots could mean the differ- duty involved was to McCook’s creditors, rejected the creditor’s argument. It found ence between a speedy resolution of the not its other members. According to the that the husband had no fiduciary duty to claims on a motion to dismiss and costly, court, “That the other member owners a creditor holding his wife’s distributional time-consuming discovery. In short, the agreed to transfer the [smelter] opportuni- interest in the LLC and, further, that the failure to adhere to corporate formalities ty away from McCook makes them jointly husband and wife, both of whom knew of that so often plagues small businesses can and severally liable, with Lynch, for a the corporate opportunity, had no obliga- make a mountain out of a mole hill in the breach of duty to the creditors; it does not tion to formally present the opportunity context of a usurpation claim. excuse Lynch.” to the corporation or to submit it to an Similarly, in Brown v. Presbyterian independent third party for evaluation. Ac- Insolvency Ministers Fund, 484 F.2d 998 (3d Cir. cordingly, the court dismissed the claim. An additional consideration is whether 1973), the president and majority share- the small business was solvent at the holder (Hoffman) of a family-owned busi- Failure to Adhere to Corporate time of the challenged transaction. This ness arranged to personally buy a mort- Formalities is important because, when a company is gage at a discount when the opportunity to The failure to adhere to basic corporate insolvent, the duties of its fiduciaries–– do so rightfully belonged to his corpora- formalities, such as documenting meet- including the duty to disclose corporate tion. The corporation filed for bankruptcy ings of the or recording opportunities––extend to its creditors. As hours after the purchase was complete. shareholder votes, unfortunately is com- the Supreme Court of Delaware recently The district court found that Hoffman had monplace among many small businesses. explained in North American Catholic Ed- not breached a duty because the acquisi- This oversight is often a product of the ucational Programming Foundation, Inc. tion was agreed to with the “knowledge cost of compliance, the casual approach to v. Gheewalla, 930 A.2d 92 (Del. 2007): and approval of all of [the corporation’s] operations taken by many small business It is well settled that directors owe fi- officers, directors and shareholders,” i.e., owners, or simple ignorance of proper duciary duties to the corporation. When Hoffman and his sons. The Third Circuit procedure. Whatever its cause, a lack of a corporation is solvent, those duties rejected this logic, finding that it could not documentation can lead to significant may be enforced by its shareholders, “countenance such a narrow view of the problems where corporate opportunities who have standing to bring derivative scope of Hoffman’s fiduciary duty. As an are concerned. actions on behalf of the corporation officer, director and principal stockholder For example, take a situation where because they are the ultimate benefi- of an insolvent corporation . . . Hoffman every shareholder knows of a corporate ciaries of the corporation’s growth and was duty bound to act with absolute fidel- opportunity, and agrees that the business increased value. When a corporation is ity to both creditors and stockholders.” should not pursue it. Some of the share- insolvent, however, its creditors take the The court explained that because Hoffman holders decide to take the opportunity for place of the shareholders as the residual had arranged the transaction with knowl- themselves, but they fail to document any beneficiaries of any increase in value. edge of his corporation’s insolvency, ap- sort of formal presentation of the opportu- And once an insolvent company files proval by the fiduciaries did not free him nity to the business or official vote of the for bankruptcy, its creditors have stand- to appropriate corporate opportunities to officers or directors. Sometime thereafter, ing to complain about the usurpation of the detriment of the corporation’s credi- perhaps because the business opportunity corporate opportunities, and they often do. tors. Corporate assent did not, therefore, turns out to be better than expected or be- A small business is no different than any relieve Hoffman of his fiduciary duties, cause the shareholders have a falling out larger company in this respect. and the “opportunity should have been over an unrelated issue, the shareholders In re McCook Metals, LLC, 319 B.R. disclosed to the receiver as representative who did not take the corporate opportu- 570 (Bankr. N.D. Ill. 2005), illustrates the of the creditors.” nity bring a lawsuit against those who did point. There, the bankruptcy trustee of a claiming that the opportunity was not fully closely-held aluminum processor (Mc- Conclusion or properly disclosed to the corporation. Cook) brought suit against McCook’s The corporate opportunity doctrine can What might have been quickly resolved principal (Lynch) for, among other things, pose significant challenges to the owners with proper documentation had corporate transferring an opportunity to acquire a of small businesses. These problems can formalities been observed now presents a smelter away from McCook. As part of be exacerbated by the failure to observe thorny factual issue. Was the opportunity his defense, Lynch argued that he had corporate formalities and, in particular,

Published in Business Law Today, August 2011. © 2011 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 3 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Business Law Today August 2011

whenever the corporation is insolvent and the rights of creditors are at stake. Still, when insolvency is not an issue, there is case law support for the notion that small business owners have the right to treat their business as their own, including by taking corporate opportunities for them- selves personally.

Mitchell L. Marinello is a partner and Christopher G. Dean is an associate at Novack and Macey LLP in Chicago.

Published in Business Law Today, August 2011. © 2011 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 4 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.